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e^sum ir m n iic n s c © July 20, 1973 The dollar strengthened in world markets last week, amid news of an expanded Federal Reserve "swap" line and rumors (later officially con firmed) of central-bank intervention to support the market. That im provement, however, came after two months of almost steady de cline. Following the two devalua tions of December 1971 and Feb ruary 1973, the dollar was effectively devalued by 15.2 percent from the pre-Smithsonian level.* After fluc tuating for several months, it weak ened again in May and June, so that effective devaluation amounted to 2 1.3 percent by July 6. Then, a week later, the figure was back up to 19.5 percent as the dollar improved. A number of factors were involved in the declining fortunes of the dollar these past several months. Foreigners seemed to be increas ingly worried during this period about the nation's political and economic stability— in particular, by the accelerating American inflation. Other factors included the tight ening of monetary and fiscal poli cies abroad, and a sharp speculative run-up in the price of gold. Under these circumstances, be cause of the many political and financial issues that are still unre solved, the present system of flex ible exchange rates undoubtedly will continue. However, centralbank intervention in the market is a possibility from time to time. To this end, the Federal Reserve an nounced last week a $6.25-billion expansion of its swap network—the reciprocal currency arrangements which the U.S. could utilize to support the dollar if it so desired. Growth of swaps The swap-line between the Federal Reserve and other central banks was developed in 1962 and substan tially expanded through the years until 1971, in an era when fixed exchange rates were the dominant mode of international transaction, and the dollar was the dominant intervention currency in the for eign-exchange market. It was de signed to facilitate foreign centralbank maintenance of the fixed-ex change rate regime, by giving the Federal Reserve the option of pro viding a temporary exchange guar antee for excess dollar holdings of foreign central banks, while mini mizing their claims on U.S. gold reserves. These lines of credit were made deliberately short (90 days with a maximum of three renewals) be cause they were intended to be used only to meet temporary sur pluses of dollars in the hands of foreign central banks. Intermediateterm dollar surpluses were to be handled via other instruments— and, of course, excessive long-term acquisition of dollars was to be handled by an official change in the exchange rate. *Dollar devaluation is com puted on the basis of the exchange rate between the dollar and the currencies of the eleven countries which have the largest trade with the United States. The base period for the computation is May 1970; thus, the floating of the Canadian dollar . since June 1970 is included in the computation. Digitized for F R A S E R (continued on page 2) F s d e m l E®s©rv© In this fixed-exchange rate era, the Federal Reserve did not normally intervene in the foreign-exchange market. Its role was to maintain a fixed value of dollars in terms of gold while all other central banks maintained a fixed rate between their national currencies and the dollar. Thus, the swap network was only used as a vehicle to facilitate foreign central bank intervention in the foreign-exchange market, that is, provide an exchange guarantee in lieu of their conversion of excess dollars into our gold holdings. It was not a source of Federal Reserve intervention in the U.S. market. When President Nixon announced suspension of gold convertibility in August 1971, the Federal Reserve simultaneously suspended all fur ther active use of the swap-lines. With a single exception early this year, there have been no new swap drawings. The suspension of swap drawings was a natural develop ment in our program of encour aging foreign central banks to set new and more realistic exchange rates rather than encouraging them to maintain the old rates. Appropriate rate? Last week's decision to expand the swap network— reinforced by the later official announcement of di rect Federal Reserve intervention in the foreign-exchange market— represents a change in the August 1971 policy. The question arises as to what induced this change. Knowledgeable observers would suggest the following. The approD ig e if f s / F s a s e B S 'ra te f o r * " * c u r rency is that which leads to equilib rium in the balance of payments. There is a strong feeling that the continued devaluation of the dollar in the private foreign-exchange market is making the dollar under valued; moving the dollar away from the exchange rate which would provide balance-of-payments equilibrium. The reason the dollar is under valued on a balance-of-payments criteria is that in its role as an international currency there has been a major stock adjustment oc curring. The devaluation of the dol lar, which was necessary to elimi nate its previous overvalued position, has simultaneously led to a reduction in the demand for dol lars as a medium for holding inter national assets. As the private market diversifies its portfolio of international assets to contain less dollars and more of other curren cies, the value of the dollar has been forced below its balance-ofpayments equilibrium value. It can be argued, under these cir cumstances, that the market is not performing its proper function and that it is necessary for the central bank to intervene to bring the ex change rate into line with long-run balance-of-payments equilibrium. In the current case, that would mean some appreciation of the dol lar, presumably by central-bank in tervention. For intervention The strongest argument for inter vening in the market is the fact that the dollar is clearly undervalued for balance-of-payments purposes. Conversely, most European curren cies and the Japanese yen are over valued. There is a long history (most recently with respect to the U.S.) where countries with overvalued currencies have tended to move toward protectionist trade legisla tion. This is designed to protect export and import-competing in dustries from the "unfair" competi tive advantages which those for eigners would now enjoy. The natural constituency in favor of free trade rapidly diminishes when the number of industries which benefit from world trade is shrinking. It can also be argued that if the present exchange-rate trend of a devaluing dollar continues, we will not only get no trade concessions from the Europeans and Japan but will most probably face new trade re strictions on our exports. This would be a major blow to the trade liberali zation moves of the last generation. Against intervention On the other hand, we have no idea of the amount of intervention needed to reverse the devaluation of the dollar. It must be remem bered that there are few capital controls on U.S. residents, so that we face the prospect of dealing not only with portfolio diversification of private nonresidents but also of all U.S. residents who may choose to re duce their dollar balances and increase their foreign-currency balances. In addition, other central banks DigitizIdfOPFRASER themselves over whelmed in their attempts to main tain exchange rates that the market does not believe viable. The classic case was that of the Bank of France, which in mid-March 1973 planned to stay open with a fixed-exchange rate when all other European banks had gone to a float. It was forced to hastily close its window in 45 min utes after it had taken in excess of $1 billion. There is no technical rea son to assume that any other central bank can be any more successful in the foreign-exchange market. Role for swaps Even if one were to accept the argument that Federal Reserve in tervention in the exchange market is both proper and effective at the present time, the swap line is prob ably not the appropriate method to mobilize the resources for such intervention. It is unlikely that the current undervaluation of the dollar is a temporary phenomena, and the swap line was designed as a short term facility to meet only temporary problems. What then is the proper role of swaps? They could be utilized to prevent "disorderly market condi tions" when and if they occur. This can be defined as roughly the for eign-exchange equivalent of a do mestic "credit crunch" where there is no price at which transactions can be conducted. In this very special ized case, private markets could be considered as having at least tem porarily broken down, so that the steadying hand of the central bank would be both desirable and wel come. Michael Reran o c=3 uojSuji|SByv\ •qeifi •uoSajo •epeA0N •oqepi MBMBH • BJU JO |!|B3 • BU O ZU y • *|I|B3 'ODSpUBJJ UBS ZSL ON HWH3d aivd 3ovisod *s*n 1IVW SSV1D JLSBIdl BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in m illions) Loans adjusted and investments * Loans adjusted— total* Com m ercial and industrial Real estate Consum er instalment U .S. Treasury securities O ther securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Governm ent deposits Tim e deposits— total* Savings O ther time I.P.C. State and political subdivisions (Large negotiable CD 's) Weekly Averages of Daily Figures Am ount Outstanding 7 / 4 / 73 Change from 6 / 27 / 73 73,868 56,526 20,126 16,533 8,391 5,730 11,612 71,063 20,898 1,005 47,702 18,096 20,339 6,577 9,713 + 444 + 341 + 8 + 73 + 41 - 45 + 148 + 19 -1 8 5 - 47 -1 6 2 + 56 + 28 -2 4 8 - 31 Change from year ago Dollar Percent + + + + + - + + + + + - + + + © © 00 Selected Assets and Liabilities Large Commercial Banks 9,979 3,211 2,825 1,351 542 581 8,053 906 150 6,840 133 5,095 1,030 4,526 ' + 15.69 +21.44 + 18.98 + 20.61 + 19.19 - 8.64 + 5.27 + 12.78 + 4.53 + 17.54 + 16.74 - 0.73 + 33.42 + 18.57 + 87.26 W eek ended 7 / 4 / 73 W eek ended 6 / 27 / 73 Com parable year-ago period 86 174 - 88 73 186 -1 1 3 + + 577 + 808 -1,264 -2 7 7 + 168 - Member Bank Reserve Position Excess reserves Borrowings Net free (+ ) / Net borrowed ( - ) 35 10 25 Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases (+ )/ Net sales ( - ) Transactions: U.S. securities dealers Net loans (+ ) / Net borrowings ( - ) 76 *lncludes items not shown separately. Information on this and other publications can be obtained by calling or writing the Admin istrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137. Opinions expressed in this newsletter Digitized for F R ^ g E ^ necessarily reflect the views of the management of the Federal Reserve Bank of http://fraser.stloui»fedrorg/i sco nor of the Board of Governors of the Federal Reserve System. Federal Reserve Bank of St. Louis B>|SB|V